Market Structure I: Perfect, Ricardian, and Williamsonian markets Paul C. Godfrey Mark H. Hansen Marriott School of Management

Why do these topics matter to strategists Perfect markets almost never occur, but form a strong analytical base case from which to draw comparisons Ricardian markets have a lot of real world features, and implications for formulating strategy Williamsons views of markets help managers make crucial decisions about vertical integration, diversification, and alliances Markets with externalities change the decision calculus

Perfectly competitive markets

Perfect competition: Assumptions Product markets Differing tastes/ preferences/ needs Identical products Price-taking consumers Full information No uncertainty No externalities Factor markets All assets completely tradable: identical products Price-taking sellers No scale economies Costless entry/ exit Full information No externalities

P P Q Q D ind S ind P ind Q ind P ind = P ff Q ff MC ff AC ff D=MR Market EquilibriumFirm Equilibrium Determining Equilibrium Price and Quantity Industry vs. Firm

P Q P ind 1 Q ff MC ff AC ff D=MR P Q P ind 2 Q ind MC ind AC ind D=MR Determining Equilibrium Price and Quantity Market Adjustment

Market clears –No excess demand No economic profit –All sellers have same cost curve –Entry/ exit stabilize price Industry supply schedule is flat Productive efficiency –All production most cost efficient $ Quantity MC ind P AC ind Industry supply curve Determining Equilibrium Price and Quantity Industry Costs and Supply

Perfect competition: Social results A market that clears leads to allocative efficiency –All consumers, producers satisfied –Only consumers get surplus Productive efficiency –All production occurs at minimum cost Pareto optimal –No one better off without someone else worse off –All mutually beneficial trades executed $ Quantity D0D0 P* Consumer Surplus Industry supply curve

Ricardian markets

The basics David Ricardo ( ) Considers corn (grain) production in the British economy All assumptions the same as perfect competition except, Plots of land are of various quality for producing corn –Variations in quality inhere in the land (non-tradable or fungible) –Differential quality is a fixed attribute –Each plot of land requires the same amount of labor to work (marginal costs are equal)

A Ricardian corn market Economic rent = the difference between the market return of a piece of land and the return of the marginal plot in production Farms (firms) earn rents on unique, valuable, and rare assets. The most valuable farm (firm) will have the lowest average cost per unit of corn Corn output/ $ Units in production Oc Oc—the opportunity cost of putting the land to the plow Marginal plot of land Rent

Ricardian markets: Social results A market that clears leads to allocative efficiency –All consumers, producers satisfied –Consumers and producers get surpluses Productive efficiency –All production occurs at minimum cost (over total output) Pareto optimal –No one better off without someone else worse off –All mutually beneficial trades executed $ Quantity D0D0 P* Consumer Surplus S0S0 Producer Surplus

Managing in (for) a Ricardian market Firms that can capture, create resources can earn rents –resources can heterogeneously distributed (rare) and immobile (costly to imitate) Resources can be endowed, as in nature Resources can be developed through investment –this is a critical point to the strategist! Resources can be managed!

Williamsonian Markets: The role of transaction costs

Transaction costs In perfect markets there are no transaction costs, or costs (risks) of doing the deal In the real world, it takes time and money to do the deal, and there are risks Four types of transaction costs –Uncertainty—all outcomes are not known in advance –Asymmetric information—some parties know more than others –Opportunism—some actors transact with guile (deception, self-serving behaviors) –Asset specificity—The difference in value between the designed use and the next best use

The make or buy decision A key decision for strategists is whether the firm should make critical inputs or buy them on the market Making it yourself is costly: –Loss of market incentives to hold costs down –Bureaucratic costs of supervision and governance Buying it on the market may be costly –Risk of opportunism impedes specialized asset investments –Costs of dealing with uncertain outcomes potentially high The critical question: When to make (integrate, acquire, alliance) and when to buy (contract)

The make or buy decision K = level of asset specificity  C= differential cost of in-house production  G= differential cost of governance in-house Cost CC GG k k’k*  C +  G

Managing in a Williamsonian world At low levels of specificity (below k*), the firm is better off to buy the input on the market At moderate levels of specificity (between k* and k’), the firm benefits from a joint-venture, alliance, or hybrid form of make-buy At high levels of specificity (above k’), the firm should integrate (acquire) the input and produce it in-house

Markets with externalities

The problem of externalities Externalities occur when the impacts of any transaction are not limited to the private parties involved –Negative—pollution in the Grand Canyon, Airplane landings –Positive—cool music, the value of MS Office Externalities represent costs (benefits) not factored into private (price) decision making Private decision rules will over- supply goods with negative externalities Private decision rules will under- supply goods with positive externalities $ Quantity MC P P SMC N SMC P QPQP Q SP QNQN

Managing in a world with externalities A popular solution: internalize the externality through taxes –Pollution tax credits Externalities cannot be factored away, or claimed as “outside” of our concern Externalities force managers to consider the social costs/benefits of their actions